- FB’s ad revenues are by nature cyclical, grew significantly more slowly in Q1, was flat year-on-year in April and may shrink for full-year 2020.
- With "investments" continuing to drive up costs, if revenues were to be flat for 2020, then EBIT would shrink by more than 40% year-on-year.
- However, FB faces no survival risk from COVID-19, its business is getting stronger, and earnings will likely recover to at least 2019 levels by 2021.
- There is a meaningful chance of a low-teens annualised return over the next 5 years with a re-rating; even without, returns will be around 10%.
- At $204.71, FB is a unique asset priced at similar multiples as other large cap companies with less growth potential. We reiterate our Buy rating.
Facebook Share Price vs. Alphabet & S&P 500 (Since 01-Mar)
NB. Librarian Capital (as "Blue Sky Capital" initiated a Buy at $171.26 on 06-Mar-19.
Source: Yahoo Finance (01-May-20).
This article re-evaluates the investment case in light of COVID-19 and 20Q1 results last week.
Buy Case Recap
Our original Buy case was based on FB being capable of grow at a 15-20% EPS CAGR after 2019, with a revenue CAGR of 15-20% driven by growth in the number of users, the number of ads per user and revenue per ad, and margins stabilizing or even improving after 2019. Valuation was attractive with a “real” Free Cash Flow yield of about 3%, comparable with quality large caps with less growth.
With COVID-19 impacting FB's inherently cyclical ad revenues at present, we believe the key questions in our investment case are:
- Does FB face any survival risk in a prolonged lockdown and recession?
- Will FB’s business suffer any structural damage during the lockdown?
- What will FB’s earnings look like when the recession is eventually over?
- Are FB shares still attractively priced relative to its post-recession earnings?
We answer each of these questions in turn below.
No Survival Risk
FB clearly does not face any survival risk, given its relative revenue resilience, high margins and high net cash.
20Q1 results last Wednesday showed some impact from COVID-19, with revenues growing "only" 17.6% year-on-year, costs and expenses growing 35.2% (excluding the FTC fine last year) due to headcount growing 28%, EBIT shrinking 6.7% and EPS shrinking 9.4%:
FB Results – Group Key Items (20Q1)
Source: FB company filings.
FB's EBIT margin was still 33.2% in 20Q1, which means the P&L could absorb large revenue declines before it turns into a loss. Net cash was $43.7bn (after the $5.0bn FTC fine, and pro forma the $5.7bn Jio investment), which on its own could fund close to a year of all costs and expenses ($47.4bn).
After a “steep” decline in March, ad revenues showed “signs of stability” (flat year-on-year) in the first 3 weeks of April, despite the lockdown. However, management was “cautious” about the remainder of 2020, seeing the potential for an “even more severe” decline in ad spend:
“We are understandably cautious given that most economists are forecasting a global GDP contraction in Q2, which, if history were a guide, would suggest the potential for an even more severe advertising industry contraction.”
Dave Wehner, Facebook CFO (20Q1 Earnings Call)
FB did not provide an outlook on revenues, but did provide revised-down 2020 guidance figures for Total Expenses ($52-56bn, vs. $54-59bn before) and CapEx ($14-16bn, vs. $17-19bn before). If we assume 2020 revenues to be flat (i.e. revenues to be lower in Q2-4 after growing 17.6% in Q1), then FB will still have full-year EBIT of $16.7bn (albeit 43.5% lower year-on-year):
FB Illustrative P&L (2020)
Source: FB company filings, Librarian Capital estimates.
No Structural Damage
Far from suffering any structural damage from the lockdown, FB has seen user number and user engagement benefited as people sheltered at home. Most notably, in U.S. & Canada (FB's most mature market), Monthly Active Users ("MAU") rose 2.0% from 19Q4 to 20Q1, the largest increase of any quarter since 2017; the ratio of Daily Active Users ("DAU") to MAU rose 50 bps from Q4, indicating higher user engagement:
Facebook-Only DAU/MAU Ratio – US & Canada (Since 2017)
NB. Figures here are for Facebook and Messenger only, and exclude Instagram & WhatsApp. Source: FB company filings.
Globally, MAU grew 4.2% (105m) from 19Q4, and was up 9.6% year-on-year, the highest growth rate since 18Q3, diverging from its long-term deceleration:
Facebook-Only Monthly Active Users Growth Y/Y (Since 2017)
Source: FB company filings.
Similarly, including WhatsApp and Instagram users, Monthly Average People ("MAP") grew 3.5% from 19Q4 to 2.99bn and Daily Average People ("DAP") grew 4.4% to 2.36bn.
FB has continued to invest and launch new products despite COVID-19, including features like Temporary Service Changes and Business Service Hub that are designed to help businesses cope with the outbreak.
Earnings After Recession
FB's recent revenue weakness is due to lower ad spend in the wider economy, even as FB's user number and ad impressions continue to grow strongly. FB's number of ad impressions in fact grew 39% year-on-year in 20Q1, a larger increase than in 2019 (33%), but offset by a 16% decline in the average price per ad, which management described as "largely attributable to the reduction in advertiser demand during the last three weeks of March".
While overall ad demand has fallen, the impact on FB was uneven in different sectors, with some showing "relative stability" or even "strong growth":
We’ve seen strong growth in gaming and relative stability in technology and ecommerce, which is one of our largest sectors ... On the other hand, we’ve seen significant declines in travel and auto, as these industries have been hit particularly hard. These trends are continuing in the first few weeks of Q2”
Sheryl Sandberg, Facebook COO (20Q1 Earnings Call)
While we cannot predict when the economy will re-open, we expect the number of ad impressions to continue to grow but at lower prices, with prices recovering after the recession. This was the pattern with Google in the last crisis, with its Cost Per Click growing 5% in 2008, declining 7% in 2009, then bouncing back 5% in 2010:
Google Components of Ad Revenue Growth (2007-14A)
Source: GOOG company filings.
Interestingly, Google described the 2009 decline was “primarily” due to currency and mix, and only “in addition” due to the downturn, while the 2010 recovery was unambiguously attributed to “increased spending from advertisers”.
The 16% decline in FB's price per ad in 20Q1 is more severe than what Google experienced in 2009, but this is likely due to digital advertising penetration now being much higher, the impact of the lockdown on consumer spending, and FB's ad price already on a down trend (down 5% in 2019) due to mix:
FB Components of Ad Revenue Growth (2007-20Q1A)
Source: FB company filings.
Our expectation is for a severe global recession, but with the economy returning to normal by 2021 year-end. As part of this, we expect aggregate ad spending level to recover in 2021, with FB's price per ad bouncing back strongly, on a volume of ads that will be much higher by then. The 2013-15 and 2017-18 periods both provide examples of how FB could raise its average price substantially. We therefore expect FB revenues in 2021 to be similar or even meaningfully higher than 2019.
The other part of earnings is costs, and FB's margin pressure from higher investments has been a concern for investors. However, management has repeatedly expressed a desire for high profit margins in the past, and re-iterated this on the 20Q1 call, providing some reassurance:
“Looking out beyond 2019 I know that we need to make sure our costs and revenues are better matched over time, and that’s something I am focused on as well”
Mark Zuckerberg, CEO (18Q3 Earnings Call)
“Beyond 2019 we will have expense growth more in line with revenue growth”
David Wehner, CFO (18Q4 Earnings Call)
“We accept that our profit margins will decrease this year as we continue investing ... But this economic pullback has certainly reinforced for me the importance of maintaining high margins.”
Mark Zuckerberg, CEO (20Q1 Earnings Call)
We therefore assume that FB's margins will not be too much worse in 2021 than 2019, and will stabilise thereafter. This means that 2021 earnings, like revenues, will likely be similar or even meaningfully higher than 2019.
At $204.71, on 2019 financials, FB shares have a P/E of 23.9x and a Free Cash Flow ("FCF") Yield of 2.5% (excluding net cash worth 7.4% of FB's market capitalisation):
FB Net Income & Cashflows (2014-19A)
Source: FB company filings.
We believe FB's valuation multiple should be at least stable, given its strong growth potential long-term, “lower for longer” interest rates, and many other quality large caps with less growth trading on similar multiples.
Indeed, FB itself has traded on significantly higher multiples in the recent past. Before Covid-19, shares peaked at $224.20 in January, which implied a 26.2x P/E (on 2019 non-GAAP EPS); the previous peak of $218.62 in July 2018 implied an even higher P/E of 40.6x on prior-year (2017) EPS:
FB Share Price (Last 5 Years)
Source: Google Finance (04-May-20).
However, with FB earnings likely to be volatile in the next 12-18 months, even on the same valuation multiple, the share price would depend on what year of financials investors apply the multiple to. The exceptional nature of COVID-19 means investors will likely write off 2020 and continue to anchor their valuation on 2019 EPS, until an earnings recovery materialises.
As described above, we believe FB's 2021 earnings will be the same or meaningfully higher than 2019.
For our Base Case, even conservatively assuming 2021 earnings will be the same as 2019, and that taking the low-end of our 15-20% EPS CAGR expectation thereafter, the 5-year EPS CAGR will still be around 10%. (For example, in a 5-year period, if EPS growth is zero for 2 years then 15% for 3 years, the overall CAGR is 8.7%.) Again conservatively assuming no upward re-rating, with share price only growing in line with EPS, FB will still generate an annualised investor return of around 10%. (However, with EPS flat or lower until 2021, the share price would in theory stagnate in this period.)
For the Upside Case, we believe there is a meaningful chance of FB re-rating upwards, giving it is a unique asset that had traded at close to 40x P/E as recently as July 2019, and many Tech companies continue to trade at 30-50x P/E. In this scenario, with P/E re-rating 25% to 30x, the 5-year annualised investor return could be in the mid-teens ("around 10%" from above, plus 25% spread over 5 years).
FB’s ad revenues are by nature cyclical, grew significantly more slowly in Q1, was flat year-on-year in April and may shrink for full-year 2020. With "investments" continuing to drive up costs, if revenues were to be flat for 2020, EBIT would shrink by 43.5% year-on-year.
However, more importantly for long-term investors, FB faces no survival risk from COVID-19, its business is getting stronger, and its 2021 earnings will likely be the same as or higher than 2019.
At $204.71, we see investors' annualised return over the next 5 years as around 10% in our Base Case (with no re-rating and 2021 earnings same as 2019) and in the low teens in our Upside Case (with a 25% re-rating to 30x P/E), which is an attractive risk/reward for such a unique asset. However, there is a risk of the share price stagnating along with earnings until 2021.
We reiterate our Buy rating on FB.
Note: A track record of my past recommendations can be found here.
This article was written by
Analyst’s Disclosure: I am/we are long FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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